Thursday, June 14, 2018

Trade, Tariffs, And Fiat Currencies

     The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups. [Henry Hazlitt, Economics in One Lesson]

     The fusillades over President Trump’s uses and threatened uses of tariffs are largely conducted in an intellectual vacuum. There’s quite a lot of moral posturing, but little reasoning. In particular, no one appears ready or willing to ask the relevant questions:

  1. What is the point of a tariff?
  2. Under what circumstances are tariffs desirable (or undesirable)?
  3. What other aspects of a nation’s fiscal and economic state are relevant to tariff decisions?

     Worse yet, when someone such as your humble Curmudgeon poses those questions, it seems no one is able to cope with them. Well, that’s what I’m here for.

1. What is the point of a tariff?

     A tariff can achieve three consequences:

  1. It can raise revenue for the government.
  2. It can discourage or prevent the importation of specific goods.
  3. It can establish an advantage in domestic trade for particular makers and sellers.

     However, whether any of those consequences are attained depends on the details of the tariff: how high it is, what goods it affects, and how it will be implemented and enforced. For example, an extremely high tariff on some non-unique item – e.g., a 10,000% tariff on imported milk – is unlikely to generate any government revenue. No one in his right mind will pay a hundred times the domestic price of milk for an imported brand. Such a tariff would effectively close the market to imported milk.

     Frederic Bastiat favored extremely low and uniform tariffs –5% on all imported goods — as a revenue-generating measure. He felt they should be paired with equally low and uniform excises on all exports, again to generate government revenue. That was also the vision of the majority of the Founding Fathers, though Alexander Hamilton did successfully campaign for tariffs to protect the U.S.’s “infant industries.”

     A government that plays favorites among domestic producers will be prone to imposing high tariffs that will shield its favorites from imported competition. Whether such a tariff is spoken of as a “protective tariff” or any other sort, the results will be the same: a reduction of choice for purchasers. Seldom is there any significant revenue from such tariffs.

2. Under what circumstances are tariffs desirable (or undesirable)?

     The answer is relatively straightforward: a tariff is desirable when it fulfills its intentions without incurring adverse consequences that are worse than the conditions that would obtain in the absence of the tariff. For example, a protective tariff that shields an industry deemed to be of strategic importance can be desirable:

  • If the nation’s military preparedness is improved thereby;
  • Without severe impacts to other industries that depend on the specified product;
  • And without creating such great ill will among the nations that severe retaliatory measures are likely.

     In a complex modern economy, the considerations that bear on such a decision can seem too complex for a definitive verdict. For example, a modest tariff on steel and aluminum as strategic metals might not have a severe effect on other industries because those metals are relatively small portions of the cost of consumer goods. However, steel is important in commercial construction; aluminum matters a great deal to the aircraft industry. The impact of a tariff on industrial expansion and aircraft sales is difficult to weigh.

     Certain tariffs are highly undesirable. For example, a high tariff on some commodity the U.S. needs in quantity but does not produce might generate significant revenue for the government, but it would have severe effects on those industries that demand it. The rare earth metals have been mentioned in this connection. America’s domestic supplies of those elements are small; we import a great amount of them. But the effect on the electronics industry in particular would be savage. Similarly, a high tariff on some ally’s most important export item could sunder the alliance, de facto if not de jure, regardless of what other effects it might have. This is no small consideration during a time of geopolitical instability.

     There’s a lot of guesswork involved...and no small amount of prayer.

3. What other aspects of a nation’s fiscal and economic state are relevant to tariff decisions?

     The most important “extra” consideration attending tariff decisions is the nature and state of the nation’s currency. When national currencies are statutorily redeemable in some commodity – e.g., gold or silver – trade balances tend to self-adjust toward equality. Flows of the redemption commodities will offset any imbalance in the flows of goods in the opposite direction. However, on today’s currency bourse things are not so simple.

     In the first decades after World War II, when the U.S. was essentially the whole of Western Europe’s defense against potential aggression from the East, billions upon billions of U.S. dollars flowed into Europe as a result of our enormous military presence there. Those dollars could be spent on U.S. exports, or redeemed for gold from the U.S. gold reserves. (Remember that at that time, though Americans were forbidden to hold gold, foreign holders of dollars could demand it in redemption of our currency at the statutory rate.) The situation was favorable to American exporters. However, it impeded Europe’s industrial redevelopment and posed a hazard to the purchasing power of the dollar.

     Unfortunately, the Nixon Administration’s “solution” was to end dollar redeemability in gold regardless of the holder. From that moment forward the dollar was a pure “fiat” currency: an instrument with no value other than what it might purchase at any moment. Thereafter the Federal Reserve Bank could create dollars without incurring any redemption obligation, whether immediate or deferred. That enabled the steady inflation of the dollar by federal borrowing.

     Now that all the world’s currencies are fiat currencies, trade balances are a matter of intense interest to all nations. If nation X has an export surplus with nation Y – measured in monetary terms, of course – that means that while Y has acquired X’s products, X has acquired a supply of Y’s currency that’s not being used to purchase Y’s export goods. As a fiat currency can only be “redeemed” by using it to purchase goods exported by the nation that issues that currency, this amounts to shipping X’s export goods abroad in exchange for promissory notes of no definite value. That tends to trigger a downward revaluation of Y’s currency, in the hope of moderating the obligation implied by its import surplus.

     Revaluations are threatening to the stability of international exchange. Tariffs are sometimes used to delay or impede them. In the example above, Y might place a tariff on X’s exports to make a revaluation unnecessary. Unfortunately, that tends to trigger retaliatory tariffs by X that significantly impede trade, with unpleasant consequences for both nations. The Smoot-Hawley Tariff Act of 1930 provides an excellent case for study. Modern economists attribute the worldwide depression of the Thirties to that tariff and the retaliations it provoked, in combination with the Federal Reserve Bank’s careless management of the dollar during the 1920s.

     The tariffs proposed by President Trump are mainly of two kinds. Some, such as the tariffs on imported steel and aluminum, are protections for strategic industries. Those are justified on the grounds of American military preparedness and our ability to sustain our armed forces in the case of a major war. Other tariffs are retaliations for other nations’ governmental subsidies to their native industries and / or their high tariffs on American export goods that would compete with those industries.

     The European Common Market is of particular interest in this regard. The EU’s internal market policies are heavily regulated to favor certain industries in certain nations. For example, EU policy protects French dairy and agricultural products against the exports of other EU nations. But of greater importance to the U.S. are the EU nations’ subsidies to their export-oriented industries and the high tariff walls the EU nations have erected against American exports. American tariffs on EU exports are much lower, and of course the U.S. doesn’t subsidize many of its domestic industries. These have given rise to a trade imbalance. Similar imbalances for similar reasons exist between the U.S. and Red China, and the U.S. and the Dominion of Canada.

     With more dollars flowing out of the U.S. than into it (as measured in “dollar equivalents” from other nations), the purchasing power of the dollar is endangered. That imperils every American’s savings. The president is right to be concerned, as Social Security and Medicare, the government’s supports for the well being of retired Americans and those soon to retire, are also under threat. Whether his tariffs can and will correct the matter remains to be seen, but his motivations are wholesome.

     Note that there is no prospect of significant revenue from those tariffs. They are intended to reduce the flow of imported goods into the U.S. and the flow of dollars out of it. While there will undoubtedly be impacts to consumer choice, a policy decision must be made as to whether that is as important as the strength of the dollar over the foreseeable future.

     There’s a lot more to be said about this subject. In particular, I should address both the effect of governmental deficit finance and whether the old “mercantilist” view of national economics is at all relevant. However, the above essay will do for a start. Please leave your thoughts in the comments.

1 comment:

Amy Bowersox said...

What is your opinion on the wage- and environmental-parity tariffs advocated by such people as Karl Denninger? This sort of tariff would be directly aimed at companies that seek to cut costs by outsourcing production to a country (like China) where they can employ de facto slave labor and spew poisons into the air, water, and ground with impunity. It would require them to pay, in tariffs, the additional money they would have had to pay by employing U.S. workers and protecting the environment to U.S. standards.